Everything you need to know about the Bright-Line Test, Interest deductions and how it affects you.
If you are planning on selling your residential property within the first five to ten years of purchasing, then this may be for you. This article highlights the importance of a bright-line test and how it can affect your capital gains, derived from the sale of properties.
What is a bright-line test?
The bright-line test was introduced and implemented by the former governing National Party in October 2015. The test is a method that taxes the financial gains made by people when property is bought and sold for income. The initial proposition of the test affected individuals who planned to sell their non-residential property within the five years of owning said property. Since 2015, the Labour Government has extended and introduced a 10-year bright-line period, for properties sold on or after the 27th of March 2021.
It is worth noting that the bright-line test does not apply to your current family home, property inherited, nor does it apply to residential assets used, that are utilised for businesses or farming purposes. This means that investment properties sold within 5 or 10 years of purchase, may be subjected to and liable for Income Tax depending on the tax rate applied.
Why was the test period extended?
The extension of the bright-line test, from 5 to 10 years, was introduced to decrease demand within the property market. As newly built homes are exempt from changes to the bright-line test, it has acted as an incentive to encourage investment in newer buildings, as opposed to existing housing. Ultimately, the decrease in demand will create relief for first home property buyers, as it continuously motivates people to build new homes.
How is the test applied?
Applying the bright-line test may, initially, seem complicated. However, In simple terms, this is what you need to consider;
The bright-line property rule does not apply to:
Property that is considered your main home
Property that has been inherited
Property from a deceased estate, which you have the executor or administrator rights to
Property obtained before the 1st of October 2015.
The bright-line property rule looks at whether the property was acquired:
On or after March 27, 2021, and sold within the 10-year bright-line period
Between the 29th of March 2018, and 26th of March 2021, and sold within the 5-year bright-line period
Capital gains made on sales are taxable if:
Purchased on or after 29th March 2018 and sold within 5 years
Purchased on or after 27th March 2021, and sold within 10 years
Purchased on or after 27th March 2021, meets the new building investment criteria, and is sold within 5 years.
Note: Properties that are acquired on or after the 27th of March 2021 will be treated as having been acquired before the 27th of March 2021. If an offer of purchase was made on or before the 23rd of March, unless revoked, the 5-year bright-line test applies.
For further clarification, the disposal of residential property within the 10 years of the bright-line test is set out in section CB 6A of the Income Tax Act 2007 (ITA 2007).
Exclusions to the bright-line rule
The main home exemption is a frequent exemption that is tested against the bright-line test. It is important to consider that the main home exemption can only be claimed twice every two years. If the owner of the property has lived and used it as their main home for at least 50% of the time in which they had ownership, an exemption may be claimed. If more than 50% of the property is leased, and the remainder is used as your main home, then a home exclusion is not applicable.
To be considered for an exemption, you must also prove that you do not have a regular pattern of buying and selling property. This will instantaneously revoke your claim to an exemption. Additionally, the exclusion does not apply to you if you did not use the property as the main home required during the bright-line period. The amount of time is measured based on the acquisition of the purchase, and when the agreement has become legally binding under the Contract and Commercial Law Act 2017.
Change-of-use rule
If your main home was not used during a consistent time frame of more than 12 months within the bright-line period, then the main home exclusion will not be applicable. The ‘change-of-use’ will then apply, and a portion of tax must be paid relating to the specific period(s). If a property is sold 7 years after the start of the bright-line period and was rented out to lessees for a specific duration, profit will be allocated between the specific duration and the remainder of the bright-line period. Therefore, It is essential for tax to be paid on the duration the property was leased to tenants. In an instance in which there is a delay in the owner moving out or into a property, the main home exclusion considers those months.
Trusts
It is important to note that the main home exclusion can only be used if the residential property was sold as the main home of a beneficiary and/or if one of the following conditions are applicable:
The principal settlor does not have a main home
It is the main home of the principle settlor of the trust that is being sold
Implications
Although the intention was to reduce pressure on first home property buyers, there have been issues arising, that come with the implementation of the bright-line test.
Co-owned properties between parents and their children are at risk for excess liabilities, as parents are unable to apply for main home exemptions if their children have purchased the remainder of property off them. Especially, If the legal title of the property has changed due to purchasing the remainder of the property. Then the original date of the purchase may not be applicable, and the more recent date of the acquisition will be the new title registered. This means that if the property is sold between the 10 years of the newly registered date, the bright-line test will apply to the portion of property that was bought, and not to the original percentage owned.
The sale of bare sections cannot be excluded under the ‘main home’ exemption as it cannot be considered a main home unless a house has been built on it. However, extensive reconstruction can possibly reset the bright-line test period. This means that properties that have initially exceeded the bright-line period, may be brought back into it. Property that is too large to be a designated lifestyle block, but too small to be labelled a farm can be captured under the bright-line test, if not primarily used for the owners’ enjoyment.
Tax Rates
The extension of the 10-year bright-line test, also known as capital gains tax, has become exceedingly complex. If the bright-line test is applicable, it is important to consider that the rate of tax on your property is measured against the capital gains profit and your annual income. Amounts from the disposal of major developments or divisions are highlighted in section CB 13 of the ITA 2007.
For instance, if you earn a salary of $80,000, your marginal tax rate would be 33%. If on the other hand, you have an annual salary of $50,000, your marginal tax rate will be split. This means that 30% will be taxed on income amounting to $70,000, and amounts exceeding this will be taxed 33%. Incomes over $180,000 will have a tax rate of 39%, on any capital gains.
In the case of GG & CE Blackburn Trustee Ltd v Croew Horwarth (NZ) Ltd, Inland Revenue had applied the bright-line test on the sale of the property. The plaintiffs claimed that the defendants had failed to correctly advise the Trust. Due to this, Inland Revenue had recognised the sale of property under the bright-line test, and the trust was liable for over $700,000 in capital gains tax. Thus, it is important to ensure that you are aware of these implications before signing any further acquisition or sale agreements, as your expected profit on a sale may differ in reality.
What does this mean for developers?
For property developers, the 10-year bright-line test has proven to be inconvenient in the ways mentioned above. Section CB 23 of the ITA 2007, states that the test is not applicable if there is an intention to dispose of property when it was initially acquired for profit-making. The involvement of land-related business also acts as an obstacle as owners can be distinguished as property developers of a business that regularly buys and sells land for profit-making purposes - Section CB 12, ITA 2007.
Additionally, the Government has announced a proposed change in legislation that will prevent residential property investors from writing off interest deductions as an expense when paying tax on rental income. Effective from the 1st of October, residential property bought on and after March 27th will be unable to claim interest deductions as an expense unless exempted. Residential properties acquired before March 27, 2021, will have their interest deductibility slowly phased out between October 1st 2021 and March 31st, 2025.
Phasing out interest deductions for properties acquired before the 27th of March 2021
1st of April 2020 to 31st of March 2021 & 1st of April 2021 to 30 September 2021 - 100% claim
1st of October 2021 to 31st March 2022 & 1st April 2022 and 31st March 2023 - 75% claim
1st of April 2023 to 31st March 2024 - 50% claim
1st April to 31st March 2025 - 25% claim
Note: These proposals will be considered by Parliament and may be subject to change
The issue that most developers will face, is the exemption criteria of a ‘new build’. The Government has proposed that new builds will be exempt from both the bright-line test and the removal of interest deductions on taxable residential property income. A newly built property is eligible for interest deduction for up to 20 years. The aim of this is to incentivize and provide added value for developers investing in newly built homes. It was claimed that this will ‘level’ the playing field for first home buyers, by increasing the supply of newly built houses, whilst decreasing the current housing prices.
Newly Built Homes
The Government has exempted specific properties from the rules of the bright-line test and interest deduction. Main homes, Maori land, commercial accommodation, farmlands, and emergency facilities are examples of property exempt from this rule. However, the exemption policy criteria will prove to be an inconvenience for property developers and investors. Although the definition of ‘new build’ is perceived to be straightforward, it leaves many developers with uncertainty. The definition of a ‘new build’ is set out as a residential property that has received its code of compliance certificate (CCC) on and/or after the 27th of March 2020. This means that eligible candidates can continue to deduct interest as an expense for up to 20 years of the time the CCC certificate was acquired and issued.
However, the issue at hand is that the exemption is measured by the issuance of the CCC certificate, and not the actual age of the property. A new build does not require to be made of new material, meaning modernised or relocated homes can fall within the scope. Any buildings that are converted into dwellings may also qualify as a new build. Thus, the definition of ‘newly built’ is left broad and unclear as there are many possible instances in which a property could fall under a ‘new build’.
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